May 3, 2012

TO: Distribution

FROM: Burt, Staples & Maner, LLP

RE: Cost Basis on Bonds and Options Delayed One Year

Occasionally, even the IRS shows some mercy.

Brokers have been phasing in cost basis reporting for stocks over the last year-and-a-half.  This year, in addition to simply tracking the basis of ordinary stock, brokers have been required to implement average basis rules for mutual fund and dividend reinvestment plan stock.

The IRS proposed regulations last November to further extend cost basis reporting to options and debt instruments effective at the beginning of 2013.  That date is consistent with the enabling statute, which says that the rules for options “shall not apply to any option which is granted or acquired before January 1, 2013” and that the bond provisions (and, arguably, the option provisions) commence on “January 1, 2013, or such later date determined by the Secretary.”

The IRS received numerous comments pointing out, on the other hand, that nothing in the statute requires that the option and bond rules go into effect next year.  Indeed, the statute gives considerable discretion to the IRS and Treasury.

The bond rules, in particular, will be difficult to implement because they require a deep understanding of the various adjustments required for original issue discount obligations.  Brokers had a long period prior to the cost basis rules during which they voluntarily offered customers cost basis information on stocks.  This was a valuable leg up on implementing the IRS cost basis rules for stocks.  The situation is quite different for bonds.  Brokers are almost certain to need at least 18 months after publication of final rules to prepare their systems for the bond provisions.  Given that the target of the cost basis reporting rules is the typical retail brokerage customer who likely does not directly own bonds, the benefit to the IRS of this dramatic increase in complexity is likely to be relatively small.

In addition, brokers are faced with the enormous task of complying with the Foreign Account Tax Compliance Act (FATCA) and the nearly 400 pages of regulations that the IRS has proposed.  FATCA goes into effect on January 1, 2013, and various requirements under FATCA become mandatory at different times between that date and 2017.

In Notice 2012-34, published earlier this week, the IRS relented.  The proposed cost basis rules for bonds and options will not go into effect until 2014.  The IRS is not being particularly generous, but the IRS also could have finalized the regulations as is, and this generosity cannot be counted on again.  Brokers should use the extra year to understand the proposed cost basis regulations and plan for their implementation.

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